Deedster/Pixabay
Mary Kleinsmith is a senior majoring in finance and was a 2020-21 Environmental Ethics Fellow at the Markkula Center for Applied Ethics at Santa Clara University. Views are her own.
At the beginning of the global COVID-19 pandemic, in February and March 2020, worldwide general capital market pricing plummeted and grew very volatile. The Dow Jones Industrial Average fell by 34% during February 2020, marking a massive deviation from the previously relatively stable market [1]. Continuing into 2020, the market’s continued volatility; caused by short-term uncertainty of economic recovery due to concerns over the pandemic’s resolution, economic shutdowns, and massive infection rates; further contributed to general uncertainty and investor apprehension.
The increased use of computer algorithms that consider daily market volatility when making daily trades exacerbated this issue, as general and day-to-day market fluctuations reinforced the trading decisions made by these algorithms [2]. As volatility rose, investors were selling their riskier assets, further contributing to the general market volatility experienced in March [2]. In early March 2020, the Federal Reserve contributed to the general market anxiety when it made two unscheduled cuts to the emergency interest rate, dropping it to a near-zero rate [2].
Despite this trend of general capital market price declines and volatility, certain sectors of capital markets showed steady or increasing pricing that was relatively nonvolatile over the course of the pandemic. One such sector, namely Environmental, Social, and Governance (ESG)-focused companies and bundled ESGs (ETFs (Exchange-Traded Funds) or bundles of investments based on ESG factors), showed such promise in bucking the general market trend as to call into question traditional views of valuing capital assets and investment decision making. If ESG investments continue to outperform comparable market indices, investors will increasingly prioritize non-financial/ESG criteria, forcing businesses to respond accordingly to draw more investor capital. The high performance of socially responsible stocks clearly demonstrates the long-term potential of ESG investment and could signal a turning point for investors to transition their strategies to take a longer-term and ethically guided approach to their investments.
From Short-term to Long-term Thinking
Traditional means of determining capital asset pricing, such as investor focus on short-term gains without considering other factors, contributed to the price declines and volatility seen at the beginning of the pandemic. Shareholders historically valued capital assets based on short-term quarterly earnings goals, and managers of these capital assets have traditionally been driven by “short-termism,” managing their business activities with the goal of meeting, or exceeding their shareholder’s short-term quarterly earnings goals [3]. The pressure to perform is significant, as a variety of surveys of executives revealed that a majority would prioritize short-term gains over longer-term value/projects [3]. When these short-term quarterly earnings goals are not met for particular capital assets, capital markets react by selling off the capital assets, resulting in lower pricing and greater volatility.
By contrast, alternative means of determining capital asset pricing do not suffer from “short-termism.” These alternative means come about when capital assets can attract a majority of investors whose focus is on the long-term value of the capital asset, rather than investors whose focus is on owning stock today and “short-termism.” In order to resolve the issue of whether a particular capital asset owes a higher duty to “short-termism” investors or long-term investors (see, e.g., [3]), capital asset managers can put out public information identifying itself in a manner that aligns its goals with those of the long-term investor and prioritizes a longer-term, sustainable approach to capital asset business practices, all to the exclusion of “short-termism.” One way that a capital asset can put out such information is to identify itself as ESG.
ESG is a set of evaluative criteria for investors prioritizing corporate and social responsibility [4]. Investors focused on ESG will prioritize the long-term sustainability and viability of a company rather than the short term quarterly gains of that company when making their investments. Sustainability factors can specifically focus on the environmental impact of business practices. Prioritizing these environmental factors lends itself to ethically and sustainably minded investing, and creates an opportunity for investors to support these businesses in a concrete way. These socially responsible ESG investors are far more likely to invest in companies that align with a designated mission or personal moral compass.
What Kind of ESG Investment?
There are a variety of ESG investments available, including single company ESG assets and exchange-traded funds (ETFs) based on multiple ESG investments.
Single company ESG investments, can be evaluated on a variety of criteria related to their overall stances toward the environment, social involvement, and corporate responsibility. The degree to which a single company meets these ESG criteria can be quite subjective, as certain measures for ESG rely more on that company’s PR team than the progress they are making to implement socially responsible business practices [4]. The subjective nature of ESG investing is further compounded by the degree to which individual investors choose to prioritize the various contributing factors that are involved in socially responsible investing, as well as the limited availability of data relating to ESG criteria [5]. However, as technology advances and data availability increases, investors will have increased access to pertinent data that will help inform their ESG investment decisions [5].
The second type of ESG investment vehicle are exchange-traded funds (ETFs), a bundle of securities, often with an underlying theme or category that is bought and sold on an exchange. ETFs allow investors to diversify their portfolios, making them less susceptible to changes in individual stocks. The more stocks represented in an ETF, the more diverse and less volatile that ETF will be, maximizing its chances as a stable investment [6].
Not Just More Ethical, but Better Performing
A 2015 review of over 2,000 individual studies concluded that approximately 90% of those studies found a positive relationship between ESG and corporate financial performance [7]. More recent pandemic-specific findings reflect a larger trend of ESG stocks performing either at par or outperforming others.
While ESG information for individual companies is primarily self-reported, a growing number of investors are including non-financial factors in their investment decision-making process, thereby encouraging companies to disclose more ESG related information. Investors’ opinions and priorities regarding their investment practices are creating a positive feedback cycle between companies prioritizing ESG factors and investors prioritizing those same factors. This positive feedback cycle allows for higher long-term yields, and more stable pricing.
Ernst & Young recently conducted a survey to determine the investor’s preferences concerning ESG investing and found that 98% of those surveyed “evaluate nonfinancial performance based on corporate disclosures, with 72% saying they conducted a structured, methodical evaluation which is up from the “32% who said they used a structured approach in 2018” [8]. These findings are especially notable when compared to a previous 2015 finding by Ernst & Young that concluded “less than a quarter of investment professionals consider extra-financial information frequently in their investment decisions” [7].
Morningstar and MSCI both reported that an overwhelming majority of their sustainable indices “outperformed their broad market counterparts” despite the increased market volatility and general uncertainty taking hold. While there were slight regional differences, the overall trend throughout the first quarter of 2020 indicated that overall “climate-focused stocks outperformed others” and ESG stocks followed suit, outperforming other stocks by approximately 7% [9].
J.P. Morgan attributed ESG indices’ outperformance during the first half of 2020 to a “reduced exposure to commodity-heavy sectors,” as those types of commodities-focused companies underperformed during the same period [10]. However, others pointed to the general correlation between sustainable businesses and low volatility, which would help to explain ESG’s success despite turmoil in other sectors [1].
Companies Are Responding to Investor Demand
Not surprisingly, companies are realizing the importance that ESG disclosures have on investors’ decisions, and an increasing number of companies are disclosing and reporting their sustainability efforts. A 2020 KPMG report analyzing thousands of companies across the globe found that 80% of those companies reported on sustainability [11]. Nonfinancial performance refers to various ESG and sustainable business practices that can be difficult to quantify yet are increasingly becoming a priority for investors. The relatively dramatic increase in investors’ focus on ESG factors within the last couple of years is notable and may be partially attributed to the resilience of ESG funds during the pandemic-induced volatility experienced during 2020 and into 2021.
Following an increasing demand in ESG investment options driven primarily by millennial demand, there has been a massive expansion in the amount of ESG-focused ETFs available on the market [4]. ESG-focused ETFs are but one kind of ESG-themed investment that thrived despite the pandemic, as assets in these ETFs reached $80 billion by July 2020 [10]. This $80 billion is more than double the amount that was invested in these ESG ETFs just the year before, emphasizing this previously marked upward trend in ESG funding, as well as the long-term viability of this type of investing [10].
Conclusion
When investors look to the future and the potential for continued volatility, the relative stability of ESG investments throughout the pandemic will likely inform their future investment decisions. As investors may push for companies to take a longer-term approach to their business practices, companies’ operations strategies will likely change to meet these demands, creating a clear pandemic-driven turning point for the market towards a more sustainable outlook.
The future of investing revolves around sustainability, as the success of ESG investing both prior and throughout the volatile pandemic highlighted the long-term viability of socially responsible and sustainably minded investing. While the uncertainty in the market can be devastating for investors, prioritizing ESG investments allowed some investors to simultaneously minimize their financial losses and prioritize their ethically minded investment strategy. Increased visibility of environmental degradation and climate change will likely bolster individuals’ interest and subsequent investment in ESGs as engaging in sustainable and environmentally focused business practices is the most logical solution for ethical, environmentally conscious individuals looking to invest in the future of a company and the future of the planet.
Works Cited
[1] “Sustainable Investing: Resilience amid Uncertainty.” BlackRock, available at: www.blackrock.com/corporate/about-us/sustainability-resilience-research
[2] Banerji, Gunjan, and Gregory Zuckerman. “Why Are Markets So Volatile? It's Not Just the Coronavirus.” The Wall Street Journal, 16 Mar. 2020, available at: www.wsj.com/articles/why-are-markets-so-volatile-its-not-just-the-coronavirus-11584393165
[3] Zimmerman, Eilene. “The Risks and Rewards of Short-Termism.” The New York Times, 4 Nov. 2015, available at: www.nytimes.com/2015/11/05/business/dealbook/the-risks-and-rewards-of-short-termism.html
[4] “ESG (Environmental, Social and Governance) - Overview and Framework.” Corporate Finance Institute, 24 Feb. 2021, available at: https://corporatefinanceinstitute.com/resources/knowledge/other/esg-environmental-social-governance/
[5] “Measuring the Immeasurable: Scoring ESG Factors.” Goldman Sachs Asset Management, Goldman Sachs, available at: www.gsam.com/content/gsam/global/en/market-insights/gsam-insights/gsam-perspectives/2015/esg/qis-article.html
[6] “Risks and Rewards of Trading ETFs.” Fidelity, Fidelity, available at: https://www.fidelity.com/learning-center/investment-products/etf/risks-rewards-trading-etfs
[7] Friede, Gunnar, Timo Busch, and Alexander Bassen. "ESG and financial performance: aggregated evidence from more than 2000 empirical studies." Journal of Sustainable Finance & Investment 5.4 (2015): 210-233. available at: https://www.tandfonline.com/doi/pdf/10.1080/20430795.2015.1118917?needAccess=true
[8] “How Will ESG Performance Shape Your Future?” EY, July 2020, available at: assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/assurance/assurance-pdfs/ey-global-institutional-investor-survey-2020.pdf
[9] Paun, Ashim. “ESG Stocks Did Best in COVID-19 Slump, Insights, HSBC.” Global Banking and Markets, HSBC. 27 Mar. 2020, available at: https://www.gbm.hsbc.com/insights/global-research/esg-stocks-did-best-in-corona-slump
[10] “Why COVID-19 Could Be a Major Turning Point for ESG Investing.” J.P. Morgan, 1 July 2020, available at: www.jpmorgan.com/insights/research/covid-19-esg-investing
[11] “The Time Has Come: The KPMG Survey of Sustainability Reporting 2020.” KPMG, Dec. 2020, available at: assets.kpmg/content/dam/kpmg/xx/pdf/2020/11/the-time-has-come.pdf